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2 Many electric utilities and load serving entities are familiar with these tools and practices, as noted earlier. 3 See, for example, Bruce Biewald, et al, ...
Typology: Summaries
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Energy Portfolio Management:
Tools and Practices for Regulators
Prepared by: William Steinhurst, David White, Amy Roschelle, Alice Napoleon, Rick Hornby, and Bruce Biewald Synapse Energy Economics 22 Pearl Street, Cambridge, MA 02139 www.synapse-energy.com 617-661-
For the Consideration of The National Association of Regulatory Utility Commissioners
4.3. Strengths and Deficiencies of Tools for Resource Planning and Procurement
4.5. Data Requirements for PM ............................................................................. 34
5. Expertise and Staffing for Portfolio Management................................................. 36
5.1. Staffing and Expertise for Portfolio Managers ............................................... 36 5.2. Staffing and Expertise for Regulators............................................................. 37
6. Conclusion ................................................................................................................. 38
Appendix A: Supply Acquisition Strategies For Default Service In States With Retail Access
Appendix B: Integrated Resource Planning Practices in Regulated States
Appendix C: Models and Tools for Portfolio Management
Appendix D: Risk Measures
1. Introduction and Summary
Ensuring that reliable retail electric service is being provided at reasonable rates is more challenging than ever.
The providers of the generation component of that retail service, regardless of the presence or absence of retail competition, face a host of major uncertainties. These include high and volatile natural gas prices, uncertain wholesale power prices, uncertainty regarding the feasibility and economics of new generation capacity, and a wide range of possible environmental regulation futures, particularly with respect to greenhouse gas emissions. Providers must address those uncertainties when choosing supply strategies, resource mix, and ownership or contracting arrangements.
Regulators are faced with the difficult task of aligning resource plans and procurement strategies with the policy objectives of their particular jurisdiction. Those policy objectives may include enhancing reliability, managing risk, improving the performance of wholesale and retail markets and achieving reasonable rates. In other words, they must determine whether the proposed resource plans and procurement strategies represent “the best” choices from the full range of viable alternative plans and strategies, given their objectives.
Regulators face these challenges both in jurisdictions with retail competition and fully regulated states. Some states, such as Delaware, have recently enacted legislation mandating changes to procurement policies.^1 Others have grappled with these issues in various regulatory proceedings to institute new or updated procurement policies. Examples of recent relevant cases and proceedings in states with, or introducing, retail competition include:
Examples of recent relevant cases and proceedings in vertically integrated states include:
The parties to such proceedings must grapple with a number of questions at both a broad and detailed level. Broad questions that arise include:
(^1) Electric Utility Retail Consumer Act of 2006, 75 Del. Laws ch. 242 (Apr. 6, 2006)
More detailed questions can also arise, such as:
The advantage to a portfolio management (PM) approach is that it provides regulators, utilities, and other parties with a systematic process and set of tools to answer such
In a 2004 report on resource planning and procurement in electricity markets sponsored by the Edison Electric Industry (EEI), the authors stated, “A synthesis is needed to meet customer needs for risk management and least-cost planning in the evolving industry structure that is a hybrid of competition and regulation.”^6
Second, there is increasing interest in meeting future electricity requirements through a diverse mix of cost-effective resources, including energy efficiency, non-traditional renewable resources, and new technologies such as distributed generation, in addition to traditional supply side resources. For example, the Energy Policy Act of 2005 (EPAct) requires consideration of a fuel source diversity standard.^7 Also, fuel diversity has been a major topic at both the 2005 and 2006 annual “Commissioners Only Summit” sponsored by National Regulatory Research Institute (NRRI). More recently, in July 2006, the President of NARUC and the Chair of EEI introduced a National Action Plan for Energy Efficiency that identifies energy efficiency as a high-priority energy resource.
This interest in applying a modern set of analytical tools to the acquisition of a diverse range of traditional and non-traditional resources is reflected in the following definition of PM, drawn from a 2006 report on clean energy policies and best practices prepared by the United States Environmental Protection Agency (EPA):
Portfolio management refers to energy resource planning that incorporates a variety of energy resources, including supply-side (e.g., traditional and renewable energy sources) and demand-side (e.g., energy efficiency) options. The term "portfolio management" has emerged in recent years to describe resource planning and procurement in states that have restructured their electric industry. However, the approach can also include the more traditional integrated resource planning (IRP) approaches applied to regulated, vertically integrated utilities.
Thus, portfolio management as applied in the electric industry may be seen as an approach to or refinement of traditional utility resource planning, which draws upon integrated resource planning, resource procurement, and risk management. 8 As such, PM encompasses three distinct components:
(^6) Graves, p. 3.
(^7) EPAct 2005 Title XII Electricity, Subtitle E, Amendments to PURPA §1251(a).
(^8) Not all concepts, tools and practices from financial markets can be applied directly to electric markets;
some may not apply while others may need to be customized. Conversely, many of the products and tools relevant to electricity portfolio management are unique to that industry.
PM can be, and is being, applied in a variety of ways. In fact, the spectrum of approaches to implementing PM ranges from a narrow, passive approach at one end of the spectrum to a comprehensive, active approach at the other.
In any given state, the policy framework and objectives that govern the retail electric market, particularly electricity supply service, will be a key factor in the choice of a PM approach from this spectrum. For example, if the explicit policy objective of a state is to strongly encourage the development of a competitive retail market for all customers, the regulator may choose to support a narrow, passive PM approach for default service so that service will be relatively unattractive or provide maximum scope for retailers to differentiate themselves. On the other hand, if the explicit policy objective is reasonable rates to all customers receiving regulated retail service, the regulator may choose a comprehensive, active PM approach for default service. Similarly, a state's policy framework may assign responsibilities in certain ways, for example relying on an Independent System Operator (ISO) or Regional Transmission Operator (RTO) to ensure reliability. The application of PM must take such divisions of responsibility into account.
Given the variation in policy objectives among the states, it is not surprising that the retail competition states exhibit a range of approaches to portfolio management. Some states have essentially no PM. In other states a narrow, passive approach is being applied to the procurement and management of resources for default service. Appendix A presents key characteristics of default service procurement in the states that we surveyed. That approach typically consists of the following components:
(^9) In some jurisdictions, slightly longer initial term lengths were used to synchronize procurement with ISO
or RTO planning and commitment cycles.
strategy composed of a diverse mix of cost-effective resources, including energy efficiency and non-traditional renewable resources, may provide the best balance of expected cost and stable rates over the long-term.
(^10) Models driven by optimization techniques may also lack fidelity in imperfect markets and situations
where decision making and investment practices are suboptimal, as is often the case.
Regulators may also consider fuel diversity targets, renewable energy targets, carbon dioxide targets, other environmental goals, service to low-income customers, impacts on the local economy, and flexibility to respond to major changes in market conditions and public policies over time.
The desire to achieve multiple objectives often complicates the determination of whether rates are reasonable, because the objectives are often conflicting. For example, one strategy might be to minimize costs for the year by purchasing all generation supplies from a spot (e.g., day ahead) wholesale market. This strategy might be premised upon a belief that a strategy that included any multi-month contracts at fixed prices would incur extra risk premium costs on average in the long run. On the other hand, this hypothetical purchasing strategy could result in very volatile costs that would necessitate some sort of routine rate true-up mechanism, and, as a result, lead to highly volatile rates for customers. A second, alternative strategy might be to stabilize rates by acquiring all supplies via long-term fixed price bilateral contracts, say through a single procurement for 100% of requirements. This alternative hypothetical strategy stabilizes rates and simplifies administration, but could result in higher expected costs than the first strategy on average over time if, for example, sellers of fixed price contracts wish to and can obtain a risk premium in return for that price certainty. Neither hypothetical strategy would satisfy both objectives of minimum costs and stable costs. In contrast, a third hypothetical strategy consisting of a mix of spot purchases and fixed price contracts might partially satisfy both objectives in a balanced manner, trading off somewhat higher costs in exchange for somewhat more stable costs, and vice versa (again, assuming that fixed price term contracts require payment of a risk premium).
One major way in which states differ is the timeframe or planning horizon over which they assess the reasonableness of the rate impacts of resource decisions. In some states regulators assess reasonableness over a short-term time frame, one to three years for example. In others regulators consider the implications of the strategy and resource mix underlying the rates over the long-term of five to twenty years, as well as assess the resulting rates expected over the short-term.
Portfolio management provides regulators, utilities, and other parties to these determinations with a process, and set of tools, to select a strategy that will result in reliable service at reasonable rates and to do so in a transparent manner. Not only can it reveal input data and assumptions, it can also identify and quantify the trade-offs between objectives under alternative strategies. That transparency can, in turn, assist regulators in determining the weight to apply to each objective.
The market structures and regulatory frameworks governing electricity supply service to retail customers vary from state to state. For the purposes of this report, those structures can be grouped under one of two broad frameworks – fully regulated or retail competition. For simplicity, this discussion will consider the retail competition framework to be a fully developed one where the provider of default service (usually the distribution company) is not allowed to retain a generation or merchant power function.
One can characterize and distinguish between those two frameworks according to the entity responsible for providing generation service and the entity responsible for ensuring that those rates are reasonable. The distinctions between the two market structures according to those attributes are summarized in Table 2.1, below.
Table 2.1 Key Attributes of Alternative Retail Market Structures Market Structure/ Attributes
Fully Regulated Retail Competition with no Merchant Function Retail competition Not Allowed Allowed
Responsibility for providing generation service Utility
Competitive market for customers who shop Default service^11 for customers who do not shop Responsibility for monitoring and oversight to ensure that generation service is reliable and reasonably priced
Regulator Regulator
Portfolio management tools and practices can be applied to the resource decisions that need to be made under either of these frameworks.
2.2.1. Application of Portfolio Management in Fully Regulated Markets
In states with a fully regulated framework, utilities employ some form of portfolio management to select and procure the appropriate resources, implicitly or explicitly. Examples from the states that we surveyed are presented in Appendix B. In these states, portfolio management is usually intertwined with resource planning procedures, such as least cost planning or integrated resource planning, where they exist. Portfolio management may also be a part of the fuel procurement practices for generation-owning utilities.
The specific procedures through which portfolio management is applied vary from state to state. However, the general approach through which the three basic steps in portfolio management are applied are summarized below.
1) Preparation and periodic updates of resource plans
Utilities are required to file a resource plan at least every two to three years. The plans cover a long-term horizon, typically at least ten years. They begin with a projection of customer electricity requirements over that period and then evaluate all options available to meet those projected requirements, including supply-side resources, transmission and distribution investments, demand-side resources and purchased power. In some cases, resource planning may encompass fuel contracting for utility-owned generators, as well as plans or policies governing
(^11) Also known as Standard Offer Service (SOS), basic generation service (BGS), and Provider of Last
Resort service (POLR)
This policy issue has been the subject of debate since the onset of retail competition. When retail competition was first introduced default service was expected to be either a temporary service during the transition to full competition or a true “default” service that relatively few customers would take, and then only while they were between competitive suppliers. Based upon that expectation, some regulators felt that a basic strategy and an annual procurement would be appropriate for the acquisition of supplies for default service.
Contrary to those initial expectations, most of these states have seen almost all residential customers as well as many small commercial, institutional, and industrial customers remain on default service. Given the number of customers who continue to rely on this service, and the recent sharp increases in the rates for that service resulting from the current acquisition approaches, regulators are now faced with the question of whether to require the use of a more complete and sophisticated portfolio management approach for the acquisition of power needed for default service.
If a regulator in a retail competition state is interested in such an approach, an important first step will likely be a review of the existing legislation, regulations, and orders governing that service. For example, changes may be required in order to assign responsibility for:
These responsibilities can be assigned to the incumbent distribution utilities or to a third party, but what is essential is that the responsibility be assigned to someone.
Resource planning and procurement have become increasingly complex over the past 20 years. Regulators need methods and tools that can be used to determine whether a particular resource plan will result in reliable service at reasonable rates.
To illustrate this challenge, consider each of the major steps involved in developing a resource plan and procuring the necessary resources.
The first step is to choose a planning horizon. Use of a reasonably long-term horizon, e.g., 20 years or more, allows a range of resources and costs to be considered, including new renewable resources that have yet to be built and anticipated carbon dioxide emission regulations. The next step is to forecast the quantity of capacity and generation
required. These requirements can be forecast, but are obviously subject to uncertainty. In addition, the quantities that will be required from hour to hour and day to day are very difficult to forecast because they are so sensitive to weather and economic conditions. In retail competition markets there is additional uncertainty as to what quantity of load will switch to, or from, competitive suppliers.
The third step is to identify the viable resources and associated contracting and hedging options. These may include:
The key attributes of each resource need to be projected for the planning horizon, including the quantities available at various points in time and their corresponding costs and volatility.
The fourth step is to then identify the alternative portfolios or strategies, consisting of different mixes of these resource options that could be used to provide reliable service at reasonable rates. This may entail evaluating hundreds of possible candidate plans or portfolios in light of the many potential permutations and combinations of these resources.
This evaluation and selection problem can, in many instances, be solved mathematically using computers by formulating it as an “optimization” problem. Under this approach the computer software is told to find the optimal mix of resources that will minimize risk while minimizing expected cost.^12 As one would expect, there are data and computational limits to solving this problem. For example, the assumptions for volatility and uncertainty in key inputs are notoriously difficult to characterize. Computationally, the vast number of possible resource combinations and timing of those mixes requires simplifying assumptions (such as trimming the available resource options down to a small handful of “typical generating unit types”) to enable the models to run in a reasonable amount of time. Portfolio management provides regulators, utilities, and other parties with a process and set of tools to analyze these complex resource planning and procurement issues. As
(^12) This would generally be a nonlinear optimization model, likely a dynamic, multi-period one.
